If You Can

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The best financial advice you can have in this millenia.

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II You Can

How Millennials Can Get Rich Slowly

William J. Bernstein ©2014
Would you believe me iI I told you that there`s an investment strategy that a seven-year-old could
understand, will take you IiIteen minutes oI work per year, outperIorm 90 percent oI Iinance
proIessionals in the long run, and make you a millionaire over time?

Well, it is true, and here it is: Start by saving 15 percent oI your salary at age 25 into a 401(k) plan, an
IRA, or a taxable account (or all three). Put equal amounts oI that 15 percent into just three diIIerent
mutual Iunds:

O A U.S. total stock market index Iund
O An international total stock market index Iund
O A U.S. total bond market index Iund.

Over time, the three Iunds will grow at diIIerent rates, so once per year you`ll adjust their amounts so
that they`re again equal. (That`s the IiIteen minutes per year, assuming you`ve enrolled in an automatic
savings plan.)

That`s it; if you can Iollow this simple recipe throughout your working career, you will almost certainly
beat out most proIessional investors. More importantly, you`ll likely accumulate enough savings to
retire comIortably.

But You`re Still Screwed

Most young people believe that Social Security won`t be there Ior them when they retire, and that this
is a major reason why their retirements will not be as comIortable as their parents`. Rest assured that
you ill get Social Security; its imbalances are relatively minor and Iixable, and even iI nothing is
done, which is highly unlikely in view oI the program`s popularity, you`ll still get around three-quarters
oI your promised beneIit.

The real reason why you`re going to have a crummy retirement is that the conventional 'deIined
beneIit¨ pension plan oI your parents` generation, which provided a steady and reliable stream oI
income Ior as long as they lived, has gone the way oI disco. There`s only one person who can repair the
gap leIt by the disappearance oI these plans, and you know who that is. Unless you act with purpose
and vigor, your retirement options may well range between moving in with your kids and sleeping
under a bridge in the rain.

Further, the most important word in this entire booklet is the


in the above 'iI you can Iollow this simple recipe,¨ because, you see, it`s a very, very big if.

At Iirst blush, consistently saving 15 percent oI your income into three index Iunds seems easy, but
saying that you can become comIortably well-to-do and retire successIully by doing so is the same as
saying that you`ll get trim and Iit by eating less and exercising more. People get Iat because they like
pizza more than Iresh Iruit and vegetables and would rather watch Monday night Iootball than go to the
gym or jog a Iew miles. Dieting and investing are both simple, but neither is easv. (And I should know,
since I`ve been much more successIul at the latter than at the Iormer.)

In your parents` day, the traditional pension plan took care oI all the hard work and discipline oI saving
and investing, but in its absence, this responsibility Ialls on your shoulders. In eIIect, the traditional
pension plan was an investing Iat Iarm that involuntarily limited calorie intake and made participants
run Iive miles per day. Too bad that, except Ior the luckiest workers, such as corporate executives and
military personnel, these plans are disappearing.

Bad things almost inevitably happen to people who try to save and invest Ior retirement on their own,
and iI you`re going to succeed, you`re going to need to avoid them. To be precise, Iive bad things
hurdles, iI you willmust be overcome iI you are to succeed and retire successIully:

urdle number one: People spend too much money. They decide that they need the newest iPhone,
the most Iashionable clothes, the Ianciest car, or a Cancun vacation. Say you`re earning $50,000 per
year, 15 percent oI which is $7,500, or $625 per month. In this day and age, that`s a painIully thin
margin oI saving, and it can be wiped out simply by stringing together several seemingly innocent
expenditures, each oI which might nick your savings by $100 or so per month: a latte per day, a too-
rich cable package, an apartment that`s a little too tony, a dress or pair oI brand-name sneakers you
really don`t need, a Iew unnecessary restaurant meals and, yes, an excessive smart phone plan you
could, iI you had to, not only live without, but also Iunction better without. LiIe without these may
seem spartan, but it doesn`t compare to being old and poor, which is where you`re headed iI you can`t
save. You might even save the whole $625 in one Iell swoop just by living with a roommate Ior a while
longer, instead oI renting your very own place. Again, as bad as having a roomie may be, it`s not nearly
as awIul as living on cat Iood at age 70.

Let`s assume you an save enough. You`re not home Iree, not by a long shot. You`ve got Iour more
barriers to get by.

urdle number two: You`ll need an adequate understanding oI what Iinance is all about. Trying to
save and invest without a working knowledge oI the theory and practice oI Iinance is like learning to
Ily without grasping the basics oI aerodynamics, engine systems, meteorology, and aeronautical risk
management. It`s possible, but I don`t recommend it. I`m not suggesting that you need to get an MBA
or even read a big, dull Iinance textbook. The essence oI scientiIic Iinance, in Iact, is remarkably
simple and can be acquired, iI you know where to look, pretty easily. (And rest assured, I`ll tell you
exactly where to Iind it.)

urdle number three: Learning the basics oI Iinancial and market historv. This is not quite the same
as the above hurdle; iI learning about the theory and practice oI Iinance is akin to studying aeronautics,
then studying investing history is akin to reading aircraIt accident reportssomething every
conscientious pilot does. The new investor is usually disoriented and conIused by market turbulence
and the economic crises that oIten cause it; this is because he or she does not realize that there`s
nothing really new under the investment sun. A quote oIten misattributed to Mark Twain has it that
'History doesn`t repeat itselI, but it does rhyme.¨ This Iits Iinance to a tee. II you don`t recognize the
landscape, you ill get lost. Contrariwise, there`s nothing more reassuring than being able to say to
yourselI, 'I`ve seen this movie beIore (or at least I`ve read the script), and I know how it ends.¨

urdle number four: Overcoming your biggest enemythe Iace in the mirroris a daunting task.
Know thyselI. Human beings are simply not designed to manage long-term risks. Over hundreds oI
thousands oI years oI human evolution, and over hundreds oI millions oI years oI animal development,
we`ve evolved to think about risk as a short-term phenomenon: the hiss oI the snake, the Ilash oI black
and yellow stripes in the peripheral vision. We were certainly not designed to think about Iinancial risk
over its proper time horizon, which is several decades. Know that Irom time to time you ill lose large
amounts oI money in the stock market, but these are usually short-term eventsthe Iinancial
equivalent oI the snake and the tiger. The real risk you Iace is that you`ll be Ilattened by modern liIe`s
Iinancial elephant: the Iailure to maintain strict long-term discipline in saving and investing.

urdle number five: As an investor, you must recognize the monsters that populate the Iinancial
industry. They`re very talented chameleons; they don`t look like monsters; rather, they appear in the
guise oI a cousin or an old college Iriend. They are also selI-deluded monsters; most 'Iinance
proIessionals¨ don`t even realize that they`re moral cripples, since in order to Iunction they`ve had to
tell themselves a story about how they`re really helping their customers. But even iI they`re able to Iool
others and oIten themselves as well, make sure they don`t Iool you.

Only iI you can clear all Iive oI these hurdles can you successIully execute the deceptively simple
'three Iund strategy¨ I`ve outlined above.

How can you deIeat these Iive demons? No Iinancial expert, no matter how smart, or how well he or
she writes, can tell you exactly how to do this within a Iew dozen pages oI a booklet like this. To
torture a metaphor, I can show you the road to Jerusalem, but since the journey takes longer than I have
within these relatively Iew pages, I can`t take you all the way there.

In other words, this inexpensive, small booklet is not a taxi cab or an airliner; it`s a map.

Acquiring the tools to make you a competent investor will take you at least several months. You can`t
learn to pilot an airplane in an hour, which is all it`ll take Ior you to Iinish this booklet, and neither can
you become a competent investor in an hour either. The good news is that you`re young and in no
particular hurry, and that the eIIort oI Iollowing the road map will be time well spent.

Now, Ior Iull disclosure. First, I`ve written a Iew investment books that continue to earn me royalties. I
don`t want you to buy them, since it`s tacky Ior an author to recommend the purchase oI his or her
works. I`ll shortly tell you what other books you should read, and in what order. Second, I`m also a co-
principal in a money management Iirm. My partner and I specialize in individuals who already have
millions; you very well might get there, but I`m old enough that by the time you do, I`ll be pushing up
the daisies. I am writing this book Ior my children, my grandchildren, and Ior the millions oI young
people who don`t have a prayer oI retiring successIully unless they take control oI their saving and
investing.

ow to read this booklet

This is, as you can see, a very short booklet and although it will take you very little time to read, you`re
going to have to read it twice, and the second time will take a while iI you do it properly.

AIter you`ve completed this booklet, about an hour Irom now, take another ten minutes and reread the
next section, beginning with 'Hurdle Number One.¨ At the end oI that section, you`ll encounter your
Iirst reading assignment, which will take you at least a week or two. II you have a busy schedule, it
may even take you a month or two.

Then reread the Iollowing section, and then complete its reading assignment, which again will take you
a Iew weeks or months. And so on, through to the end oI the booklet.

This may take you up to a year, but you`re in no hurry, since you are just beginning to think about your
retirement and you likely have little in the way oI assets; you may even be in hock up to your ears with
debts Irom school and car loans. So there`s plenty oI time, and the months you take to complete the
course laid out in the booklet will be the most proIitable reading you will ever do; it may not be too
much oI an exaggeration to suggest, in Iact, that your Iinancial liIe depends on it.

With that out oI the way, let`s get started.

urdle Number One: Even if you can invest like Warren Buffett, if you can`t save,
you`ll die poor.

How much do you need to save? We`ll get into deeper math in the next section, but, as already
mentioned, iI you`re starting to save at age 25 and want to retire at 65, you`ll need to put away at least
15° oI your salary.

BeIore you can save, you`ll oI course have to get yourselI out oI debt. In thinking about just how to do
this, it helps to compare your expected investment return with the interest you`re paying on your debt.

Every situation is diIIerent, but a Iew basic principles apply to everyone. First, no matter how much
debt you have, always, always max out the employer match on your 401(k), 403, or other deIined
contribution retirement plan, since the 'return¨ on this money is usually between 50° and 100°,
which is higher than even the worst credit card interest rates. (From now on, I`ll use the term '401(k)¨
to reIer to any employer-sponsored deIerred compensation plan.)

Next, eliminate your credit card debt, Iollowed by your car loan. What about your educational loans?
Since your long-term investment return on your retirement savings will be around 5°, which is likely
lower than your loan interest rate, you should make paying oII those your next priority. When, and only
when, you`ve gotten rid oI all your debt are you truly saving Ior retirement.

The above paragraph raises a subtle but important point about retirement savings. Note that I quoted an
'expected return¨ oI 5° Ior your retirement saving. We`ll skip over Ior now how I arrived at that
Iigure, but Ior the moment, I`ll point out that this 5° number is not adjusted Ior inIlation; that is, it is a
'nominal¨ rate oI return. I did this so as to more accurately compare it to the loan and credit card
interest rates you may be Iacing.

For the purposes oI retirement savings, though, it`s better to think about returns that have been adjusted
Ior inIlation, that is, 'real¨ rates. Currently, Ior example, long-term inIlation appears to be running at
around 2°, so the above 5° expected nominal return oI your investments calculates out to a 3° real
return, and what matters is the spending power oI your portIolio, that is, its real value, not the nominal
value you`ll see on your brokerage or mutual Iund statements. From now on, we`re only going to talk
about real returns and dollar amounts, not nominal returns and dollar amounts; every time you see a
dollar Iigure, you`ll have to remember that this is in terms oI spending power in the year 2014. One
Iinal point: this means that in the above example, planning on saving $625 per month beginning in
2014 means you`ll have to increase that savings amount with inIlation; this should not be diIIicult,
since you can expect that your salary should increase by at least that rate.

I`ll end this section, as I mentioned above, with a reading assignment: Thomas Stanley and William
Danko`s he Millionaire Next Door. This is the most important book you`ll ever read, because it
emphasizes the point that there`s an inverse correlation between spending and saving. (Statisticians and
economists like to pooh-pooh this book Ior its methodological Ilaws, which admittedly are many. These
blemishes, though, in no way detract Irom the lucid way in which Millionaire dissects the corrosive
eIIects oI our consumer-oriented society on both personal and societal well being.)

My Iather was a modestly successIul attorney who, because he began his career a Iew years beIore the
onset oI the Depression, became a compulsive saver. Consequently, our house, vacations, and
automobiles were not as Iancy as those oI our neighbors. When I`d ask him why this was, he`d reply
that our neighbors oned a lot, but didn`t have a lot. In Iact, he`d slyly add, he knew Ior a Iact that
more than a Iew oed a lot. (When I was younger, I`d ask him iI we were rich: 'Your mother and I are
comIortably well to do. You don`t have a dime.¨)

Stanley and Danko systematically studied the characteristics oI millionaires. Some not-so-surprising
Iacts: the most common millionaire car was an F-150 truck, which oIIered the most pounds oI vehicle
per dollar. A plumber making $100,000 per year was Iar more likely to be a millionaire than an attorney
with the same income, because the latter`s peer group was Iar harder to keep up with. And so Iorth. II
this book doesn`t scare your spending habits straight, nothing will.

urdle Number Two: Finance isn`t rocket science, but you`d better understand it
clearly.

Do you know the diIIerence between a stock and a bond? Maybe you do, and maybe you don`t, but a
little review never hurts.

Say you`re starting a business. It`ll be a bit beIore it starts making money, but Irom day one it`ll have
expenses, and you`ll need money Ior that up Iront.

You can get that money in one oI two ways: you can borrow it Irom relatives, Iriends, or Irom a bank,
or you can sell an ownership interest to a Iriend or Iamily member. For example, iI your brother is halI
owner, he`s entitled to halI oI all oI your business`s Iuture earnings.

Nothing prevents you Irom doing both, and in Iact that is what most large corporations do. II you do
both borrow money and sell shares, then both legally and morally, you have to pay the lenders` interest
and principal Iirst. Only aIter they have been paid, and only aIter your other ongoing business expenses
have been met, can you then pay out the remaining proIits to you and your brother.

You and your brother are thus the 'residual owners¨ oI the business; iI, and only iI, you can pay oII
your lenders and your expenses do you make any money. From the investors perspetive, an
onership stake (a stok) is muh riskier than a loan to vour business (a bond), and so the stok
deserves a higher expeted return than a bond.

The term 'expected return¨ causes a lot oI grieI among neophyte investors. It`s only what`s expeted,
i.e., the average result; the risk is the chance that it will Iall short. A coin toss that oIIers a dollar Ior
heads and nothing Ior tails, Ior example, has an expected return oI IiIty cents, but there`s also the 50/50
risk you`ll get nothing.

Here`s a good way to think about the relationship between expected return and risk. You`d probably
preIer a certain IiIty cents Ior each and every coin Ilip rather than a 50/50 chance oI a dollar or nothing.
In Iact, most people would preIer even a certain Iorty cents; only at twenty or thirty cents oI certain
payoII would the average person preIer the coin Ilip; this is the point where the higher expected return
oI the coin Ilip adequately compensates Ior the 50 percent chance oI getting nothing. (Economists use
examples like this to gauge 'risk aversion.¨ The person who will not take a penny less than a certain
IiIty cents to avoid the coin toss has zero risk aversion; the person who will take a certain ten cents to
avoid the coin toss is highly risk averse. This paradigm is a good way to think about your own risk
aversionthat is, how much risk you can tolerate.)

Put another way, bond ownership has no other upside beyond the Iull repayment oI interest and
principal, so it needs to be saIe; stocks, on the other hand, need to have their potentially unlimited
upside to entice investors who must endure their high risk. Put yet another way, iI stocks and bonds
were equally risky, no one would own the bond, with its limited upside; conversely, iI stocks and bonds
had the same return, no one would want to own the stocks, with their higher risk.

This raises a more subtle point, and one that is oIten not well understood by even sophisticated
investors, which is that the interests oI the owners oI stocks, who are willing to take considerable risks
to get higher returns, and the owners oI bonds (or, in the case oI a small business, the Iolks loaning it
money), who care only about saIety, are very diIIerent, and it`s a company`s stock owners who get to
vote, not the bond owners. For this reason, loans to businessescorporate bondsare in general a bad
deal, and it is a good idea to conIine your bond holdings to government oIIerings.

How risky are stocks? You`ve no idea. During the Great Depression, stocks lost, on average, around 90
percent oI their value; during the recent Iinancial crisis, they lost almost 60 percent. Although you
might think that you can tolerate this kind oI loss, guess again. It`s one thing to think about temporarily
losing 60 percent or even 90 percent oI your savings, the actual experience, in the moment, is
unimaginably upsetting. In the words oI Fred Schwed, one oI the most astute observers oI the
investment scene (and certainly the Iunniest):
There are certain things that cannot be adequately explained to a virgin either by words
or pictures. Nor can any description I might oIIer here even approximate what it Ieels
like to lose a real chunk oI money that you used to own.
Is it possible to predict when such declines might occur, and so avoid them? Don`t even think about it:
in the past 80 years, no one, and I mean no one, has ever done so reliably. Like a broken clock that is
right twice a day, many have predicted a single bear market Iall, but their Iuture Iorecasting ability
always evaporates, exactly what you`d expect Irom a lucky guess, and not Irom skill.

Is it possible to Iind a mutual Iund manager or advisor who can beat the market? Again, no: several
decades oI careIul research have shown that managers with superb prior perIormance usually Iall Ilat
on their Iaces going Iorward. (Over the past decade, even Warren BuIIett has Iailed to beat the market
by any signiIicant margin.)

The simplest way to think about investing 'skill¨ is to imagine a stadium containing 10,000 people.
Everyone stands up and Ilips a coin: heads you stay up, tails you sit down. The laws oI probability tell
us that aIter 10 coin Ilips, on average about 10 Ilippers will still be standing. Were they skillIul? OI
course not. The poster child Ior this phenomenon is a money manager named William Miller, whose
Legg Mason Value Trust mutual Iund beat the S&P 500 index oI stocks Ior fifteen straight years beIore
giving back nearly all oI his cumulative advantage over that index in just three short years.

Think about it another way. Say you could time the market or successIully pick stocks. Would you be
publishing a newsletter, telling people about your predictions on TV, running a mutual Iund, or, ha ha,
working as a stock broker? OI course not. You`d borrow as much money as you could, bet on your
predictions with that borrowed money, and go to the beach. (You might also run a hedge Iund, and so
direct much oI the upside to yourselI and all oI the downside to your clients.) When all is said and
done, there are only two kinds oI investors: those who don`t know where the market is headed, and
those who don`t know that they don`t know. Then again, there is a third kind: those who know they
don`t know, but whose livelihoods depend on appearing to know.

II you don`t Iind that convincing, think about investing in yet another way: When you buy and sell
stocks, the person on the other side oI the tradethe person or organization you`re buying Irom or
selling toalmost certainly has a name like Goldman Sachs or Fidelity. And that`s the best case
scenario. What`s the worst case? Trading with a company insider who knows more about his employer
than 99.9999° oI the people on the planet. Trading stocks and bonds is like volleying with an invisible
tennis opponent. More oIten than not, that person turns out to be one oI the Williams sisters.

II I had to summarize Iinance in one sentence, it would go something like this: iI you want high returns,
you`re going to occasionally have to endure Ierocious losses with equanimity, and iI you want saIety,
you`re going to have to endure low returns. At the end oI the investing day, only two kinds oI assets
exist: risky ones (high returns and high risks, namely stocks), and what are known in Iinance as
'riskless¨ ones (low risks and low returns, like T-bills, CDs, and money market Iunds). Job one Ior the
investor is to Iigure out the appropriate mix oI the two. For example, the three-Iund portIolio presented
at the beginning oI this book consists oI two thirds risky assets and one third riskless assets.

While it`s impossible to estimate the returns oI the stock or bond markets tomorrow, or even next year,
it`s actually not too diIIicult to estimate them in the very long term. First, government bonds. The 30-
year U.S. Treasury bond, as oI this writing, yields around 3.6°. This is a pretty good estimate oI its
return over the next 30 years. But this is a nominal return, and recall I just told you that you want to
think in real, inIlation-adjusted terms. Well, the Treasury also oIIers a 30-year inIlation-protected
security (TIPS), that currently has a real 1.4° yield and return oI real principal, both oI which rise over
time with inIlation. So the expected real return oI the 30-year bond is . . .1.4°.

Stocks are only slightly more complicated. Domestic stocks currently yield a dividend oI around 2°,
Ioreign stocks around 3°. This is a real yield, since historically the real dividend payout increases at
around 1.5° per year. Since the stock price should increase roughly in line with this growth in
dividends, the real return oI stocks should be the sum oI the current yield and the growth ratethat is,
Ior domestic stocks, the 2° yield plus the 1.5° growth rate, or 3.5°, and Ior Ioreign stocks, about
4.5° (the 3° dividend plus the 1.5° dividend growth).

Thus, a portIolio that is two thirds stocks and one third bonds should have a long-term expected real
return oI around 3°, and this is also where the suggested 15° savings rate Ior someone who starts
saving at age 25 comes Irom. Most young people are Iamiliar with MicrosoIt Excel, so I`ve uploaded a
spreadsheet that shows the eIIects oI varying returns rates and saving rates in terms oI real,
accumulated assets aIter 20, 30, and 40 years to www.eIIicientIrontier.com/Iiles/savings-path.xls. The
name oI the game is to accumulate around 12 years oI living expenses (cells H12 to H16), which,
combined with Social Security, should provide Ior a reasonable retirement. How did I arrive at 12 years
oI living expenses? The average person needs to accumulate about tentv-five years oI living expenses,
and I`m assuming you`ll be getting about halI oI that Irom Social Security.

So much Ior an introduction to basic Iinance. Your next reading assignment is Jack Bogle`s ommon
Sense on Mutual Funds, perhaps the best introduction to basic Iinance that`s ever been written.

I`ll end this section with one more bit oI Iull disclosure. I`m proud to call Jack Bogle an acquaintance,
but he`s also the Iounder oI the Vanguard Group, which is now the world`s largest mutual Iund
company. Four decades ago, he made a IateIul decision, which was to give ownership in the company
to the shareholders of the mutual funds. That is to say, when you own a Vanguard mutual Iund, vou are
the owner oI the company that oIIers it. Because Vanguard`s shareholders own it, the company has no
incentive to gouge them with excessive Iees and hidden expenses.

This is the only mutual Iund company Ior which this is true; when you own the shares oI any other Iund
company, you are not the owner, and it is in the interest oI the company`s real ownersthe stock
shareholders or private owners oI the Iund companyto keep Iees high.

Consequently, Vanguard`s Iund expenses are generally the lowest in the industry, and the company is
my go-to Ior most investors, whether they have a Iew thousand dollars or hundreds oI millions. I have
occasionally been accused oI being a 'shill¨ Ior Vanguard; iI wanting to be the owner oI my Iund
company and so pay rock-bottom Iees makes me a shill, then I plead guilty.

Jack Bogle, while not a poor man, would almost certainly be a billionaire many times over had he
retained ownership in the company, instead oI giving it away to the Iund shareholders. He is the only
person in the history oI the Iinancial services industry to have done so and, as you might expect, he has
remained, long aIter his retirement, a strong and clear voice Ior the rights oI small investors
everywhere.

Long may he live.

urdle Number Three (with apologies to George Santayana): Those who ignore
financial history are condemned to repeat it.

There is no greater cause oI mischieI to the small investor than the conIusion between the health oI the
economy and stock returns. It`s natural Ior people to assume that when the economy is in good shape,
Iuture stock returns will be high, and vice versa.

The exact opposite is in Iact true: market history shows that when there`s economic blue sky, Iuture
returns are low, and when the economy is on the skids, Iuture returns are high; it is a truism in the
market that the best Iishing is done in the most stormy waters. In the late 1990s, Ior example, people
thought that the Internet would change everything. It did, but it didn`t help the economy that much, and
over the next decade stocks suIIered not one, but two bone-crushing bear markets that resulted in more
than a decade oI negative real returns. By contrast, investors who bought stocks in the depths oI the
Great Depression (and in the depths oI the more recent Iinancial crisis) made out like bandits.

By now you know enough investment theory to understand this paradox: since risk and return are
inextricably intertwined, high risk and high returns go hand in hand, and so do low risk and low
returns. When the economy looks awIul, risks seem high, and so stocks must oIIer high returns to
entice people to buy them; contrariwise, when the economy looks great and stocks seem saIe, they
become more attractive to people, and this yields low Iuture returns. Another way to put it is that the
biggest proIits are made by buying at the lowest prices, and stocks only get cheap when bad economic
news abounds; thereIore, the highest returns are earned by buying when the economy is in the toilet,
and vice versa.

Learning market history isn`t just about knowing the past pattern oI returns (though that`s helpIul). In
addition, it`s about learning to recognize the market`s emotional environment, which also correlates
with Iuture returns.

The 1929 market peak oIIered a classic example oI the value oI being attuned to sentiment; when asked
how he knew to sell stocks the year beIore, Joseph Kennedy Sr. was said to have answered that when
the shoeshine boys started oIIering him stock tips, he knew it was time to get out. In the 1990s, I had
two 'shoeshine boy moments.¨ The Iirst came when I saw a TV advertisement Ior an online brokerage
Ieaturing a day trader who had just acquired his own island; the second came when a relative who did
not know the Iirst thing about investing joined her Iirst stock club. (One version oI the island
commercial is available here: http://www.youtube.com/watch?v÷1lnwkXb3B-k.) Similarly, you may
have observed how during the early 2000s it seemed as though halI your Iriends were Ilipping houses
and brokering real estate and mortgages.

Why the correlation between popular interest and subsequent low returns? Simple: Driving the price oI
any asset higher requires the entry oI new buyers, and when evervone is invested in stocks, real estate,
or gold, there`s no one leIt to join the party; the entry oI naïve, inexperienced investors usually signals
the end.

Market bottoms behave the same way; when everyone is aIraid oI stocks, then there`s no one leIt to
sell, so prices are much more likely to move up than down.

Put another way, we oIten depend on the recommendations oI others Ior, say, restaurants, movies,
doctors, or accountants; when all your Iriends report Iavorably on one, there`s a pretty good chance that
the recommendation is valid. Finance, though, Ior the reasons explained above, is the exact opposite;
when all your Iriends are enthusiastic about stocks (or real estate, or any other investment), perhaps you
shouldn`t be, and when they respond negatively to your investment strategy, that`s likely a good sign.

A working knowledge oI market history reinIorces this sort oI proIitable but highly counterintuitive
behaviori.e., to have seen the movie beIore.

Does the ability to recognize excessive market optimism or pessimism mean that you can 'time¨ the
market? No, it does not. Rather, you should use your knowledge oI Iinancial history simply as an
emotional stabilizer that will keep your portIolio on an even keel and prevent you Irom going all-in to
the market when everyone is euphoric and selling your shares when the world seems to be going to hell
in a hand-basket.

Then again, the discipline oI maintaining a Iixed allocation, such as the 33/33/33 portIolio mentioned at
the beginning oI the book, is an easy and eIIective Iorm oI market timing, since it oI necessity means
that you will be buying more stocks aIter signiIicant market Ialls, when pessimism reigns, and selling
some stocks aIter prolonged and dramatic price rises, when the market seems to be making everyone
rich. The real purpose oI learning Iinancial history is to give you the courage to do the selling at high
prices and the buying at low ones mandated by the discipline oI sticking to a Iixed stock/bond
allocation.

Section Three`s homework is a pair oI treats, Devil ake the Hindmost by Edward Chancellor, a
compendium oI stock market manias; and its bookend, he Great Depression. A Diarv, by Benjamin
Roth, a portrait oI how things look at the bottom. The lives oI most investors encompass the two
diIIerent kinds oI markets described in these books, and they will provide a beacon that will guide you
through both the best oI times and the worst oI times.

urdle Number Four (with apologies to Walt Kelly, creator of the cartoon):
We have met the enemy and he is us.

As you may already have guessed, the person most liable to screw up your retirement portIolio is you.
A superb example oI just how this happens is Iound in the March 29, 2013 edition oI all Street
Journal, in which reporter Jonathan Cheng described an agreeable, attractive married physician couple,
Lucie White and Mark Villa. Wrote Mr. Cheng,

Feeling 'sucker punched,¨ |by the global Iinancial crisis| they swore oII stocks and put
their remaining money in a bank. This week, as the Dow Jones Industrial Average and
Standard & Poor's 500-stock index pushed to record highs, Ms. White and her husband
hired a Iinancial adviser and took the plunge back into the market. 'What really tipped
our hand was to see our cash not doing anything while the S&P was going up,¨ says Ms.
White, a 39-year-old dermatologist in Houston. 'We just didn't want to be leIt on the
sidelines.¨

This story speaks volumes about just how human nature can derail even the best designed portIolio.

In order to understand just how this happens, we need to consider the basics oI human evolution. In a
state oI nature, the biggest risks to human existence tend to be attacks by predators and by other
humans, and an ability to react instinctively and quickly carries real survival value. As human beings
advanced Irom agricultural to industrial to postindustrial societies and as health and longevity
improved, survival and the quality oI liIe began to depend on a shiIt to long-run decision makingup
to a time horizon oI several decades.

Long-term planning, oI course, is what investing is all about, and it`s a predisposition that our maker
most deIinitely did not endow us with. The nearly instantaneous emotional responses that served us so
well on the prehistoric AIrican plains turn out to be Iatal in Iinance, as maniIested in the buy-high sell-
low behavior epitomized by the Villa-Whites.

And that`s just Ior starters. Human nature turns out to be a virtual Petrie dish oI Iinancially pathologic
behavior. People tend to be comically overconIident: Ior example, about eighty percent oI us believe
that we are above average drivers, a logical impossibility. (Men tend to be much worse on this count,
and thus worse investors than women.) We tend to extrapolate the recent past indeIinitely into the
Iuture; in the 1970s, investors thought that inIlation would never end, whereas now most people think it
will never occur again. The Iirst viewpoint was proven wrong within a Iew years, and the latter
viewpoint most likely will be soon. Both long bear and bull markets also seem to take on a liIe oI their
own.

Most importantly oI all, humans are 'pattern seeking primates¨ who perceive relationships where in
Iact none exist. Ninety-Iive percent oI what happens in Iinance is random noise, yet investors
constantly convince themselves that they see patterns in market activity.

Statistics proIessors use this classic demonstration in introductory courses: the instructor leaves the
room and asks all but one oI the students to record the results oI 30 coin tosses. The one remaining
student, chosen by the class without the knowledge oI the proIessor, is asked to simulate the tosses with
pen and paper.

The proIessor returns and is able to quickly identiIy the single student who simulated the coin tosses.
How? His or her simulations almost never contain 4 or more straight heads or tails, which almost
always occur within 30 random coin tosses. The point here is that runs oI 4 or more heads or tails are
pereived as a nonrandom pattern, when in Iact they are in Iact the rule in random sequences, not the
exception. Stock market participants Irequently make this mistake, and an entirely bogus Iield oI
Iinance known as 'technical analysis¨ is devoted to Iinding patterns in random Iinancial data.

Once again, your homework in this section is a real piece oI chocolate cake, Your Monev and Your
Brain, by the all Street Journal`s Jason Zweig; I can guarantee you that you`ll enjoy it immensely,
and iI Jason can`t save you Irom yourselI, then no one can.

urdle Number Five: The financial services industry wants to make you poor and
stupid.

It`s sad but true: by the time you`ve completed the reading Ior the previous Iour hurdles, you`ll know
more about Iinance than the average stock broker or Iinancial advisor.

You should avoid them, since their main goal is to transIer your wealth to them. This advice also
applies to most mutual Iund companies, Ior the reason mentioned previously: they exist to make proIits
Ior their owners, not you.

In Iact, the prudent investor treats almost the entirety oI the Iinancial industry landscape as an urban-
combat zone. To be avoided at all costs are: anv stock broker or 'Iull-service¨ brokerage Iirm; anv
newsletter; anv advisor who purchases individual securities; anv hedge Iund. Most mutual Iund
companies spew more toxic waste into the investment environment than a third-world reIinery. Most
Iinancial advisors can`t invest their way out oI a paper bag.

Brokers and advisors may appear to be skilled proIessionals, but don`t be Iooled. Doctors, lawyers, and
accountants all have the equivalent oI post-graduate degrees and had to study Ior years to pass grueling
exams, yet your broker was not required to graduate high school. Further, people do not go into the
Iinancial services industry Ior the same reasons that attract individuals to social work, government
service, or elementary education.

Why isn`t the public as well protected Irom malIeasance in the brokerage industry as it is in medicine,
dentistry, accounting, and the law? The reason is that all Iour oI these proIessions are highly regulated,
and their practitioners deviate Irom standard procedure only at great peril to their livelihood. II a
physician Iails to recognize and treat with powerIul antibiotics more than one or two cases oI obvious
bacterial pneumonia, his license will get yanked with gusto. Ditto Ior the accountant or attorney who
regularly Ialls below the standard oI practice.

The message oI the preceding pages couldn`t be clearer; don`t come anywhere near a stock broker or a
brokerage Iirm; sooner rather than later you will get Ileeced. It`s a little known Iact that stock brokers
do not owe their clients what is known as 'Iiduciary duty¨the obligation that most other
proIessionals have to put their clients` interests above their own. Without this, you`ll have little legal
protection Irom a broker`s incompetence and mendacity absent outright Iraud or the sale oI an
outrageously unsuitable investment.

Avoiding brokers (and advisors who, unlike brokers, do owe clients Iiduciary responsibility) is harder
than it seems, since they`re liable to be your old college roommate, brother-in-law, or church or service
organization member. The best way oI solving this problem is to deItly change the subject when these
Iolks bring the conversation around to Iinance or, iI you don`t mind a little Iibbing, to tell them that you
have no interest in money management. However you choose to handle this, a ready routine Ior
deIlecting approaches Irom Iriends and relations in the Iinance industry is an essential survival skill.

The terrain presented by the mutual Iund industry is only slightly less hostile, but because it Ieatures
greater transparency and the legal protections oIIered by the 1940 Investment Company Act, it oIIers
you at least a Iighting chance oI emerging with your wealth intact.

Still, all is not well in the mutual Iund world; since Iund company revenues Ilow proportionately Irom
assets under management (AUM), mutual Iund companies Iocus primarily on growing the size oI their
Iunds, not on your returns. The good news is that the linkage between these two is Iar tighter than it is
with a brokerage account. Since Iunds regularly report perIormance and Iees, and since you can so
easily move your assets Irom a Iund Iamily`s stock Iund to your money market Iund, Irom which a
check can be written, there is less opportunity Ior monkey business.

Still, you`ll need to exert extreme care with mutual Iunds. Except Ior the Vanguard Group, a mutual
Iund or brokerage company has two sets oI masters: the clients who purchase the mutual Iunds or
stocks and bonds in the Iunds and brokerage accounts, and the shareholders who own the stock oI the
brokerage or Iund company itselI. Every company`s goal is to maximize the bottom line oI the latter
its real ownersand mutual Iund and brokerage Iirms can only do this at the expense oI their clients
that is, you. And iI you think that your interests are the same as the Iund company`shigh investment
returnsthen guess again. By the time you Iigure out how it`s Ileecing you, it will have made Iar more
in excessive management Iees than it might have made with the higher returns that come Irom lower
expenses. (In other words, iI a Iund company raises its Iund Iees Irom 1.0° to 1.5°, it has just raised
its revenues by 50°, but you are unlikely to notice its eIIect on your perIormance Ior many years, iI
ever.) This same logic applies in spades to brokers, as well, who are very highly trainedin selling, not
in Iinance.

To summarize, you are engaged in a liIe-and-death struggle with the Iinancial services industry. Every
dollar in Iees and expenses you pay them comes directly out oI your pocket. (Be aware that you`re
oIten getting charged Iar more in mutual Iund Iees than that 'expense ratio¨ listed on the prospectus or
annual report, which is oIten exceeded by the 'transactional costs,¨ that is, adverse price changes that
result Irom moving around millions oI shares, much oI which accrues indirectly to the Iund company.)
Act as iI every broker, insurance salesman, mutual Iund salesperson, and Iinancial advisor you
encounter is a hardened criminal, and stick to low-cost index Iunds, and you`ll do just Iine.

Now Ior the good news: you`ve already done the homework Ior this section, which is the same as Ior
Section Two, ommon Sense on Mutual Funds. So you`ve almost Iinished the reading list.

What about the nuts and bolts?

So, how do you actually implement the investment plan outlined above? As mentioned in the Iirst
section, your biggest priority is to get yourselI out oI debt; until that point, the only investing you
should be doing is with the minimum 401(k) or other deIined contribution savings required to 'max
out¨ your employer match; beyond that, you should earmark every spare penny to eliminating your
student and consumer debt.

Next, you`ll need an emergency Iund placed in T-bills, CDs, or money market accounts; this should be
enough Ior six months oI living expenses, and should be in a taxable account. (Putting your emergency
money in a 401(k) or IRA is a terrible idea, since iI you need it, you`ll almost certainly have to pay a
substantial tax penalty to get it out.)

Then, and only then, can you start to save seriously Ior retirement. For most young people, this will
mean some mix oI an employer-based plan, such as a 401(k), individual IRA accounts, and taxable
accounts.

There are two kinds oI IRA accounts: traditional and Roth. The main diIIerence between the two comes
when you pay taxes on them; with a traditional account, you get a tax deduction on the contributions,
and pay taxes when the money is withdrawn, generally aIter age 59½. (You can withdraw money
beIore 59½, but, with a Iew important exceptions, you`ll pay a substantial tax penalty Ior doing so.)
With a Roth, it`s the opposite: you contribute with money you`ve already paid taxes on, but pay no
taxes on withdrawals in retirement.

There`s thus not a lot oI diIIerence between a 401(k) and a traditional IRA; in Iact, you can seamlessly
roll the Iormer into the latter aIter you leave your employer. In general, the Roth is a better deal than a
traditional IRA, since not only can you contribute 'more¨ to the Roth (since $5,500the current
annual contribution limitoI aIter-tax dollars is worth a lot more than $5,500 in pre-tax dollars), but
also you`re hopeIully in a higher tax bracket when you retire.

Your goal, as mentioned, is to save at least 15 percent oI your salary in some combination oI
401(k)/IRA/taxable savings. But in reality, the best strategy is to save as much as you can, and don`t
stop doing so until the day you die.

The optimal strategy Ior most young people is thus to Iirst max out their 401(k) match, then contribute
the maximum to a Roth IRA (assuming they`re not making too much money to qualiIy Ior the Roth,
approximately $200,000 Ior a married couple and $120,000 Ior a single person), then save in a taxable
account on top oI that.

A Irequent problem with 401(k) plans is the quality oI the Iund oIIerings. You should look careIully at
the Iund expenses oIIered in your employer`s plan. II its expense ratios are in general more than 1.0°,
then you have a lousy one, and you should contribute only up to the match. II its expenses are in
general lower than 0.5°, and particularly iI it includes Vanguard`s index Iunds or Fidelity`s Spartan-
class Iunds (which have Iees as low as Vanguard`s), then you might consider making signiIicant
voluntary contributions in excess oI the match limits. For most young savers, Iully maxing out
voluntary 401(k) contributions (assuming you have a 'good¨ 401(k) with low expenses) or the annual
Roth limit will get them well over the 15 percent savings target.

Your contributions to your 401(k), IRA, and taxable accounts should be made equally to the indexed
U.S. stock, Ioreign stock, and bond Iunds available to you. Once per year, you should 'rebalance¨ them
back to equal status. In the good years, this will mean selling some stocks, which you should avoid
doing in a taxable account, since this will incur capital gains taxes. In practice, this means keeping a
Iair amount oI your stock holdings in a tax sheltered 401(k) or IRA. This will not be a problem Ior the
typical young investor, since he or she will have a relatively small amount oI his or her assets in a
taxable account.

The Iollowing are some examples oI the kinds oI index Iunds you`ll want to use. II your 401(k) is lucky
enough to have Vanguard Iunds, look Ior, respectively, the (U.S.) Total Stock Market Index Fund, Total
International Stock Index Fund, and either the Short-Term Bond Index or Total Bond Market Index
Fund. As already mentioned, the Fidelity Spartan series is also excellent: the Total Market Index,
International Index, and U.S. Bond Index (or Short-Term Treasury Bond Index) Iunds.

Increasingly, 401(k) plans are making 'target Iunds¨ the deIault contribution choice. For example,
Vanguard oIIers Target Retirement Iunds, which carry Iees oI 0.16°0.18°, aimed at those retiring
between 2010 (geezers) and 2060 (twenty-year olds) in 5-year increments (2060, 2055, 2050, and so
Iorth, down to 2010). The 2060 Iund, Ior example, has a 90° allocation to stocks, which will then Iall
by a percent or so each year as the saver gets older.

This is about as Iar as I can take you in this book with the nuts and bolts. There`s nothing magic about a
portIolio consisting oI equal parts U.S. stocks, Ioreign stocks, and bonds; you might want a higher or
lower allocation to each oI these, and you might even want to 'slice and dice¨ the U.S. and Ioreign
stock components into smaller component pieces such as real estate investment trusts (REITs),
emerging and developed markets Ior Ioreign stocks, and so Iorth. And, as I`ve said, there`s nothing
wrong with an all-in-one target retirement Iund, as long as it has low expenses.

Since Section Five had no homework assignment, I`m going to double up the reading assignment with
two books: Allan Roth`s Ho a Seond Grader Beats all Street and Rick Ferri`s All About Asset
Alloation.

That`s it. As I told you in the beginning, iI you`ve completed your Iirst pass through the booklet, take a
deep breath and start with the Section One reading assignment, he Millionaire Next Door, then
continue with the rest.

There are a number oI things I haven`t told you, the most important oI which is how to spend down
your money in retirement. At present, the best way oI doing this is the purchase oI an inIlation-adjusted
Iixed annuity, which mimics the payout oI a traditional pension plan, or a 'ladder¨ oI inIlation-
protected bonds (TIPS) that matures every Iew years, to provide you with an inIlation-adjusted income
stream. Estate planning is another issue I haven`t discussed, since it`s even Iurther out in the Iuture.

The reason I haven`t talked about either retirement spending or estate planning is that both will not
become important to you Ior many decades, by which point the relevant investment options and tax law
will almost certainly be very diIIerent Irom today`s. So it`s just not worth thinking about these two
issues now. In other words, you`re way too young Ior these things to matter, Ior the simple reason that
they`ll be very diIIerent by the time they do.

Back to the present; iI this is the end oI your second pass through the booklet, and you have thus
completed all oI the sectional reading lists, then you`re ready to start on your journey to a reasonably
well-to-do retirement.

Good Iortune!

William Bernstein
Portland, OR
March 2014

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